I don’t have to tell you that 2020 has been a difficult year. You’ve not only read about it ad nauseum as the headlines are filled with national restaurant chains seeking Chapter 11 bankruptcy relief, but many of you have lived it as you try to guide your businesses so they can remain afloat while keeping your customers, employees and yourselves safe—all while navigating a constantly changing playing field.
The effects of COVID-19 permeate throughout our economy and will reverberate for decades based upon shifting consumer and commercial habits. Consumer activity will likely shift back to pre-COVID-19 levels over the next few years in some instances (dine-in restaurants and cinemas), while other behaviors have likely shifted paradigms for the long-term (grocery delivery and, to my wife’s delight, wine delivery). But, there may be a “vaccine” hidden in amendments to the Bankruptcy Code that could help small businesses through these “unprecedented times.”
Faster, Less Expensive Bankruptcy Proceedings
On February 19, 2020, Congress enacted the Small Business Reorganization Act of 2019 (“SBRA”), which created the new subchapter V to chapter 11 (“Sub V”) with the goal of making small business bankruptcy proceedings faster and less expensive. Specifically, Sub V holds the promise of improving the likelihood of reorganization for a viable small business debtor by reducing the time, expense and certain legal impediments to the confirmation of a chapter 11 plan. The timing for this new avenue could not have been better.
“Small business debtors” who qualify for this option are defined as those engaged in commercial or business activities with the aggregate noncontingent liquidated secured and unsecured debts of not more than $2,725,625. To qualify, more than fifty percent of debts must be from commercial or business activities of the debtor. Single asset real estate is excluded from this count, but SBRA expanded the prior definition to include businesses whose primary activity is owning or operating real estate.
Overlaid on this construct of helping these qualifying small businesses reorganize was the temporary expansion of access to Sub V via the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), which was enacted on March 27, 2020 and increased the total debt cap from $2,725,625 to $7,500,000. Unless it is further amended, this increase debt limit sunsets on March 27, 2021. The Sub V has proven quite popular and has accounted for approximately 20 percent of new Chapter 11 filings this year. Given its popularity and the current state of the economy, there is a case to be made for this sunset date will be extended, but because there is no guarantee that will occur, daylight is wasting on this opportunity if your debts are less than $7,500,00.
Business Opportunity under Sub V Bankruptcy
Did I say opportunity? Yes, opportunity. Any restructuring process should begin with straightforward blocking and tackling: (i) attempt to reduce your fixed overhead via amendments or concessions, (ii) extend terms with your vendors to preserve cash flow and (iii) modify loan terms that recognize the new normal. But what if you can’t get buy in from the counter-parties or if you otherwise see creative new strategies in the future, like converting to a virtual restaurant, but can’t get buy-in? Perhaps Sub V is the right pathway for you.
For those small business debtors who qualify for and elect to utilize this option, Sub V, among other things, (i) does away with the absolute priority rule stipulating priority creditor payments and allows an owner to retain their equity in the company and participate in future upside, (ii) expedites and favors the Debtor in plan confirmation and post-confirmation modifications, and (iii) stops administrative expenses from suffocating a reorganization.
While it would be impossible to describe all aspects of Sub V in this article, the high points are quite extraordinary (at least to a bankruptcy practitioner like myself) and an extraordinary departure from prior relief given under chapter 11. Overall, the process to getting a plan confirmed is streamlined compared to regular chapter 11 cases. While Sub V still requires that the debtor meet the traditional elements necessary for confirmation under chapter 11, it offers an easier path to a cramdown plan, which is a bankruptcy plan confirmed by a court despite objections by a class of creditors. The only real requirements for a plan to meet this favorable path is that the plan provides that all projected disposable income of the debtor to be received in the 3-5-year period following confirmation will be applied to plan payments and that the value of the distributions is not less than the debtor’s projected “disposable income.” The elimination of chapter 11’s impaired class requirement means that the small business debtor won’t necessarily need any friendly creditors in order to reach confirmation.
Perhaps the most consequential shift in the Sub V cases is the elimination of the absolute priority rule (the “APR”). Under the APR, waterfall provisions require that equity cannot be paid unless and until all unsecured creditors are paid in full, which results in the elimination of equity in almost every bankruptcy case (i.e. the owner has lost the upside in the venture going forward as typically existing debt is converted to new equity). The elimination of the APR allows equity holders to retain ownership of the debtor even if creditors are not paid in full. Remember, opportunity.
Another opportunity is presented via the dramatic benefits to post-confirmation modifications that weigh in the Debtor’s favor and make the elimination of the APR even more important. Under Sub V, only the Debtor may modify the plan post-confirmation. This means that, if the business improves dramatically, there is no pathway for a creditor to request a modification of the plan to increase the proposed payments. If that weren’t enough, if the business declines, the Debtor, in certain instances, retains the right to request a modification of the plan – even if the plan has been substantially consummated.
Lastly, Sub V also allows the debtor administrative claims to be paid over time throughout their case rather than at confirmation. Germane to restaurants is the fact that lease payments and goods received by the debtor in the twenty days pre-filing, which would otherwise need to be paid for at confirmation, can receive administrative expense priority—rendering many a case administratively insolvent.
By decreasing the time and expense necessary while streamlining the process and allowing owners to retain equity in contravention to the APR, small businesses now have the ability and incentive to reorganize under Sub V and retain their business without having to win over creditors or repay all of the business debts in full.